Allocations with Respect to Contributed Property (revised) Howard E. Abrams Warren Distinguished Professor, USD School of Law May Copyright 2015 by Howard E. Abrams

Substantial Economic Effect Under §704(b)  The substantial economic effect requirement is satisfied only if tax allocations correspond with the associated economic (i.e., book) allocations. This means that allocations of taxable income must be coupled with a right to receive additional value at liquidation (or sooner) while allocations of loss must reduce claims on partnership assets.  One consequence is that partners are taxed as the partnership recognizes income and deductions and so liquidating distributions of cash should be tax free.

Substantial Economic Effect: Example  X and Y each contribute cash of $10,000 to the XY partnership. The partnership earns $2,000 in its first year, and the partners agree to allocate the economic profit 60% to X and 40% to Y. Thus, if the partnership liquidates now, X will receive $11,200 while Y will receive $10,800.  The partners are, in general, free to allocate the economics however they like, but tax allocations must follow book allocations.

Substantial Economic Effect: Analysis XY CAOBCAOB 10,000 Contributions

Substantial Economic Effect: Analysis XY CAOBCAOB 10,000 Contributions 1, Book (Economic) Allocations

Substantial Economic Effect: Analysis XY CAOBCAOB 10,000 Contributions 1, Book (Economic) Allocations 01, Tax Must Follow Book

Substantial Economic Effect: Analysis XY CAOBCAOB 10,000 Contributions 1, Book (Economic) Allocations 01, Tax Must Follow Book 11,200 10,800 Totals

Book and Tax Allocations (revised)  First, allocate book items in accordance with the partnership agreement subject to the requirement of “substantial economic effect.”  Second, allocate tax equal to book as required by §704(b).  Third, if there is tax without book, the extra tax is allocated under §704(c). If there is less tax then book, there is a ceiling limitation problem.

Built-In Gain  Section 704(c)(1)(A) provides that “income, gain, loss and deduction with respect to property contributed to the partnership by a partner shall be shared among the partners so as to take account of the variation between the basis of the property to the partnership and its fair market value at the time of the contribution.”  The regulations provide that this means built-in gain in contributed property must be allocated to the contributing partner when that gain is recognized by the partnership.

Built-In Gain: Example  Assume P contributes cash of $10,000 to the PQ partnership while Q contributes nondepreciable property with adjusted basis of $6,000 and fair market value of $10,000. Assume further that they agree to be equal partners except as required by section 704(c).  The statute provides that the inside basis of the contributed property as well as the outside basis of Q is carried over from the Q’s adjusted basis in the property; that is, each equals $6,000. The regulations provide that Q’s capital account equals the fair market value of the contributed property at the time of contribution, or $10,000. Thus, the “built-in gain” equals $4,000.  Assume the property eventually is sold for $12,000.

Example: Analysis PQ CAOBCAOB 10,000 6,000Contributions

Example: Analysis PQ CAOBCAOB 10,000 6,000Contributions 1,000 Book Gain (Partnership Agreement)

Example: Analysis PQ CAOBCAOB 10,000 6,000Contributions 1,000 Book Gain (Partnership Agreement) 1,000 Tax Gain Under §704(b)

Example: Analysis PQ CAOBCAOB 10,000 6,000Contributions 1,000 Book Gain (Partnership Agreement) 1,000 Tax Gain Under §704(b) 0004,000Tax Gain Under §704(c)

Example: Analysis PQ CAOBCAOB 10,000 6,000Contributions 1,000 Book Gain (Partnership Agreement) 1,000 Tax Gain Under §704(b) 0004,000Tax Gain Under §704(c) 11,000 Totals

Accounts Payable  While partnership liabilities are covered by section 752, accounts payable contributed to a partnership by a cash-basis contributor are not treated as “liabilities” but rather as property described in section 704(c) with a $0 adjusted basis and a negative fair market value. Thus, such payables have a book/tax disparity when contributed to the partnership, and the usual rules under section 704(c) apply.

Accounts Payable: Example  A and B are equal partners in the AB general partnership. Each partner has an outside basis and capital account of $40,000. The partnership owns Purpleacre with adjusted basis of $80,000 and value of $100,000. C is admitted as a one-third partner, and A and B each reduce their interest from one-half to one third. C contributes accounts receivable of $65,000 and accounts payable of $15,000 from her cash basis business in exchange for her partnership interest. The partnership elects to book-up its assets immediately prior to the admission of C. Eventually, Purpleacre is sold, the receivables are collected, and the payables are paid.

Accounts Payable: Analysis ABC CAOBCAOBCAOB 40,000 Starting Values

Accounts Payable: Analysis ABC CAOBCAOBCAOB 40,000 Starting Values 10,000 Book-Up

Accounts Payable: Analysis ABC CAOBCAOBCAOB 40,000 Starting Values 10,000 Book-Up 65,0000Contribution of Receivables

Accounts Payable: Analysis ABC CAOBCAOBCAOB 40,000 Starting Values 10,000 Book-Up 65,0000Contribution of Receivables -15,0000Contribution of Payables

Accounts Payable: Analysis ABC CAOBCAOBCAOB 40,000 Starting Values 10,000 Book-Up 65,0000Contribution of Receivables -15,0000Contribution of Payables Sale of Purpleacre: §704(b)

Accounts Payable: Analysis ABC CAOBCAOBCAOB 40,000 Starting Values 10,000 Book-Up 65,0000Contribution of Receivables -15,0000Contribution of Payables Sale of Purpleacre: §704(b) 10,000 Sale of Purpleacre: §704(c)

Accounts Payable: Analysis ABC CAOBCAOBCAOB 40,000 Starting Values 10,000 Book-Up 65,0000Contribution of Receivables -15,0000Contribution of Payables Sale of Purpleacre: §704(b) 10,000 Sale of Purpleacre: §704(c) ,000Collection of Receivables

Accounts Payable: Analysis ABC CAOBCAOBCAOB 40,000 Starting Values 10,000 Book-Up 65,0000Contribution of Receivables -15,0000Contribution of Payables Sale of Purpleacre: §704(b) 10,000 Sale of Purpleacre: §704(c) ,000Collection of Receivables ,000Payment of Payables

Accounts Payable: Analysis ABC CAOBCAOBCAOB 40,000 Starting Values 10,000 Book-Up 65,0000Contribution of Receivables -15,0000Contribution of Payables Sale of Purpleacre: §704(b) 10,000 Sale of Purpleacre: §704(c) ,000Collection of Receivables ,000Payment of Payable 50,000 Totals

Depreciation Example  Now assume the property is depreciable using the straight-line method over five years, so that the partnership is entitled to a depreciation deduction of $1,200 per year for five years.  Reg. § (b)(2)(iv)(g)(3) provides that book depreciation is to book value as tax depreciation is to adjusted basis. Accordingly, because tax depreciation equals one-fifth of adjusted basis each year (or $1,200 per year), book depreciation equals one-fifth of book value per year (or $2,000 per year).

 First, we determine how book depreciation will be allocated according to the partnership agreement subject to the rules of §704(b).  Next, we allocate to the noncontributing partner as much tax depreciation as equals her share of the book depreciation.  Lastly, we allocate the remaining tax depreciation to the contributing partner. Depreciation

Depreciation Analysis PQ CAOBCAOB 10,000 6,000Contributions The property has a book value of $10,000 and an inside basis of $6,000.

Depreciation Analysis PQ CAOBCAOB 10,000 6,000Contributions -1,0000 0Year 1 Book Depreciation

Depreciation Analysis PQ CAOBCAOB 10,000 6,000Contributions -1,0000 0Year 1 Book Depreciation 0-1, Year 1 Tax Depreciation

Depreciation Analysis PQ CAOBCAOB 10,000 6,000Contributions -1,0000 0Year 1 Book Depreciation 0-1, Year 1 Tax Depreciation 9,000 5,800Totals The property now has a book value of $8,000 and an inside basis of $4,800.

Depreciation Analysis PQ CAOBCAOB 10,000 6,000Contributions -1, Year 1 Depreciation -1, Year 2 Depreciation 8,000 5,600Year 2 Totals Notice how the book/tax disparity is reduced by $800 per year. The property now has a book value of $6,000 and an inside basis of $3,600.

Depreciation Analysis PQ CAOBCAOB 10,000 6,000Contributions -1, Year 1 Depreciation -1, Year 2 Depreciation 8,000 5,600Year 2 Totals Notice how the book/tax disparity is reduced by $800 per year. -1, Year 3 Depreciation -1, Year 4 Depreciation -1, Year 5 Depreciation 5,000 Totals

Depreciation and Disposition Example  Reconsider this example but assume that the property is sold for $12,000 after the partnership has held it for 3 years. Some of the built-in gain will have been burned off via the depreciation allocations while the remainder will be handled at disposition. Again, there will be book depreciation of $2,000 per year and tax depreciation of $1,200 per year, so after three years the property will have a book value of $4,000 and an inside basis of $2,400. When the property is sold for $12,000, there will be a book gain of $8,000 and a tax gain of $9,600. The t-accounts will look as follows:

Depreciation and Disposition: Analysis XY CAOBCAOB 10,000 6,000Contributions -3, Years 1-3 Depreciation 4,0000 0Disposition Book Gain 04,0000 Disposition §704(b) Tax Gain 0001,600Disposition §704(c) Tax Gain 11,000 Totals

Ceiling Limitation Example  Reconsider the PQ partnership in which P contributes cash of $10,000 and Q contributes nondepreciable property with adjusted basis of $6,000 and fair market value of $10,000. Now assume that the partnership eventually sells the property for $7,000. On that sale there is a book loss of $3,000 but a tax gain of $1,000. The “ceiling limitation” provides that the partnership can only allocate so much taxable gain and loss as it recognizes. Here, that means no tax loss can be allocated and only $1,000 of tax gain can be allocated.

Ceiling Limitation Analysis PQ CAOBCAOB 10,000 6,000Contributions

Ceiling Limitation Analysis PQ CAOBCAOB 10,000 6,000Contributions -1,500 Book Loss (Partnership Agreement)

Ceiling Limitation Analysis PQ CAOBCAOB 10,000 6,000Contributions -1,500 Book Loss (Partnership Agreement) 0001,000Tax Gain (Section 704(c))

Ceiling Limitation Analysis PQ CAOBCAOB 10,000 6,000Contributions -1,500 Book Loss (Partnership Agreement) 0001,000Tax Gain (Section 704(c)) 8,50010,0008,5007,000Totals

Solutions to the Ceiling Limitation Problem  Reg. § (b) - The Traditional Method  Reg. § (c) - The Traditional Method with Curative Allocations  Reg. § (d) - The Remedial Allocation Method

The Traditional Method PQ CAOBCAOB 10,000 6,000Contributions -1,500 Book Loss (Partnership Agreement) 0001,000Tax Gain (Section 704(c)) 8,50010,0008,5007,000Totals

The Traditional Method PQ CAOBCAOB 10,000 6,000Contributions -1,500 Book Loss (Partnership Agreement) 0001,000Tax Gain (Section 704(c)) 8,50010,0008,5007,000Totals Do nothing: live with the book/tax disparities until the partners exit the venture. In general, use of the traditional method is desired by the contributing partner and disliked by the noncontributing partner.

The Traditional Method with Curative Allocations  Assume that the partnership has additional book and tax income of $4,000 in the year of disposition. If the partnership were using the traditional method, this income would be allocated $2,000 to each partner for both book and tax purposes.  But using the Traditional Method with Curative Allocations, allocation of the taxable income (not the book income) is skewed to eliminate the book/tax disparities.

The Traditional Method with Curative Allocations PQ CAOBCAOB 10,000 6,000Contributions -1,500 Book Loss (Partnership Agreement) 0001,000Tax Gain (Section 704(c)) 8,50010,0008,5007,000Totals

The Traditional Method with Curative Allocations PQ CAOBCAOB 10,000 6,000Contributions -1,500 Book Loss (Partnership Agreement) 0001,000Tax Gain (Section 704(c)) 8,50010,0008,5007,000Totals 2,000 Unrelated Book Income ,500Skew Tax Allocations 10,500 Totals

The Traditional Method with Curative Allocations and Depreciable Property Now suppose Q’s contributed property has an adjusted basis of only $4,000 when contributed and that this property is depreciable over five years using the straight line method. Also assume PQ receives unrelated income of $600 each year. PQ CAOBCAOB 10,000 4,000Contributions -1, ,0000Depreciation 9,0009,2009,0004,000Totals

The Traditional Method with Curative Allocations and Depreciable Property Now suppose Q’s contributed property has an adjusted basis of only $4,000 when contributed and that this property is depreciable over five years using the straight line method. Also assume PQ receives unrelated income of $600 each year. PQ CAOBCAOB 10,000 4,000Contributions -1, ,0000Depreciation 9,0009,2009,0004,000Totals 300 Unrelated Book Income Skew Unrelated Tax Income 9,300 4,500Totals

Curative Allocations and Depreciable Property (continued) PQ CAOBCAOB PQ CAOBCAOB 10,000 4,000Contributions -1,0000 0Book Depreciation Tax Depreciation Cure with Unrelated Income 9,300 4,500Totals -4,000-3,200-4,0000Years 2-5 Depreciation 1, ,2002,000Years 2-5 Cure 6,500 Totals The noncontributing partner generally prefers the curative method.

The Remedial Allocation Method  Under this method, depreciable appreciated property contributed to a partnership is divided into two components, one unappreciated and one having a zero-basis. This method treats a contribution as if two properties have been contributed.  The unappreciated asset is depreciated using a step-in-the-shoes rule while the wholly appreciated asset is treated as newly placed in service.  The book and tax depreciation for any year is the sum of the depreciation from the two assets.

The Remedial Allocation Method Example  When a ceiling limitation causes a book/tax disparity, the partners cure the disparity by manufacturing tax allocations to cure. Reg. § (d)(1).  The manufactured tax allocations will always net to zero.  Continue the PQ example assuming the depreciable property has a remaining useful life of 5 years, and assume the partners have agreed to use the remedial allocation method. Finally, assume there is a statutory recovery period of 10-years if newly placed in service and that all depreciation is recovered ratably.

The Remedial Allocation Method (revised) Unappreciated ComponentZero-Basis Component Fair Market Value: 4,000 Adjusted Basis: 4,000 Depreciation schedule continues: Thus, with 5 years remaining, Year 1 book depreciation = 4,000/5 = 800 Year 1 tax depreciation = 4,000/5 = 800 Fair Market Value: 6,000 Adjusted Basis: 0 Depreciation schedule starts fresh: Thus, with 10 years remaining, Year 1 book depreciation = 6,000/10 = 600 Year 1 tax depreciation = 0/10 = 0 Therefore, the overall year 1 book depreciation = = 1,400 and the overall year 1 tax deprecation = 800.

The Remedial Allocation Method: Analysis PQ CAOBCAOB 10,000 4,000Contributions

The Remedial Allocation Method: Analysis PQ CAOBCAOB 10,000 4,000Contributions Year 1 Depreciation

The Remedial Allocation Method: Analysis PQ CAOBCAOB 10,000 4,000Contributions Year 1 Depreciation -2, Years 2-5 Depreciation

The Remedial Allocation Method: Analysis PQ CAOBCAOB 10,000 4,000Contributions Year 1 Depreciation -2, Years 2-5 Depreciation 6,500 3,500Totals Now that the unappreciated portion of the property has been fully depreciated, so there is only book depreciation remaining.

The Remedial Allocation Method: Analysis PQ CAOBCAOB 10,000 4,000Contributions Year 1 Depreciation -2, Years 2-5 Depreciation 6,500 3,500Totals Year 6 Depreciation

The Remedial Allocation Method: Analysis PQ CAOBCAOB 10,000 4,000Contributions Year 1 Depreciation -2, Years 2-5 Depreciation 6,500 3,500Totals Year 6 Depreciation Year 6 Remedy

The Remedial Allocation Method: Analysis PQ CAOBCAOB 10,000 4,000Contributions Year 1 Depreciation -2, Years 2-5 Depreciation 6,500 3,500Totals Year 6 Depreciation Year 6 Remedy -1,2000 0Years 7-10 Depreciation

The Remedial Allocation Method: Analysis PQ CAOBCAOB 10,000 4,000Contributions Year 1 Depreciation -2, Years 2-5 Depreciation 6,500 3,500Totals Year 6 Depreciation Year 6 Remedy -1,2000 0Years 7-10 Depreciation 0-1,20001,200Years 7-10 Remedy

The Remedial Allocation Method: Analysis (correct) PQ CAOBCAOB 10,000 4,000Contributions Year 1 Depreciation -2, Years 2-5 Depreciation 6,500 3,500Totals Year 6 Depreciation Year 6 Remedy -1,2000 0Years 7-10 Depreciation 0-1,20001,200Years 7-10 Remedy 5,000 Totals

Reverse §704(c) Allocations to the Existing Partners  “Reverse §704(c) allocations” are actually allocations under §704(b) which are based on §704(c) principles.  Reverse §704(c) allocations arise whenever a partnership elects to revalue its assets and restate capital accounts (a “book-up”).  The most common “book-up” events are the contribution of property or services to a partnership and the distribution of property from a partnership. Note: both contributed property and distributed property must be booked to fair market value; the optional book-up refers to other assets of the partnership.

Reverse 704(c) Allocation Example (correct)  Suppose the XY partnership owns a single nondeprecible asset with an adjusted basis of $50,000 and fair market value of $80,000. If Z wants to join the partnership on an equal footing with X and Y, how much should Z be required to contribute to the partnership? What will happen to X and Y’s t-charts? And if the partnership eventually sells the property for $170,000, how should the book and tax gain be allocated?

Reverse 704(c) Allocation Analysis XYZ CAOBCAOBCAOB 25,000 Pre-Admissions Values

Reverse 704(c) Allocation Analysis XYZ CAOBCAOBCAOB 25,000 Pre-Admissions Values 15,0000 0Book-Up from $50,000 to $80,000

Reverse 704(c) Allocation Analysis XYZ CAOBCAOBCAOB 25,000 Pre-Admissions Values 15,0000 0Book-Up from $50,000 to $80,000 40,00025,00040,00025,00040,000 Admission of Z Totals AssetBook ValueInside Basis Property80,00050,000 Cash40,000

Reverse 704(c) Allocation Analysis XYZ CAOBCAOBCAOB 25,000 Pre-Admissions Values 15,0000 0Book-Up from $50,000 to $80,000 40,00025,00040,00025,00040,000 Admission of Z Totals 30, Allocation of Book Gain BookTax Gain on Sale170,000–80,000 = 90,000170,000–50,000 = 120,000

Reverse 704(c) Allocation Analysis XYZ CAOBCAOBCAOB 25,000 Pre-Admissions Values 15,0000 0Book-Up from $50,000 to $80,000 40,00025,00040,00025,00040,000 Admission of Z Totals 30, Allocation of Book Gain 030, Allocation of §704(b) Tax Gain AssetBook ValueInside Basis Cash210,00040,000

Reverse 704(c) Allocation Analysis XYZ CAOBCAOBCAOB 25,000 Pre-Admissions Values 15,0000 0Book-Up from $50,000 to $80,000 40,00025,00040,00025,00040,000 Admission of Z Totals 30, Allocation of Book Gain 030, Allocation of §704(b) Tax Gain 015, Allocation of §704(c) Tax Gain AssetBook ValueInside Basis Cash210,00040,000

Reverse 704(c) Allocation Analysis XYZ CAOBCAOBCAOB 25,000 Pre-Admissions Values 15,0000 0Book-Up from $50,000 to $80,000 40,00025,00040,00025,00040,000 Admission of Z Totals 30, Allocation of Book Gain 030, Allocation of §704(b) Tax Gain 015, Allocation of §704(c) Tax Gain 70,000 Totals AssetBook ValueInside Basis Cash210,00040,000

Observations  Application of §704(c)(1)(A) to any book/tax disparity in property contributed to the partnership is mandatory.  Restating partnership assets to FMV upon admission of a new partner (and apply §704(c) principles) nominally is optional. See Reg. § (b)(2)(iv)(f).  However, failure to revalue (and apply §704(c) principles) might be characterized as a gift or otherwise. See Reg. § (b)(2)(iv)(f)(last sentence)

Allocations with Respect to Contributed Property Howard E. Abrams Warren Distinguished Professor, USD School of Law May Copyright 2015 by Howard E. Abrams